Transfer Pricing: Criticism for Recent Methods

Posted by I Wayan Agus Eka on August 25, 2010

Transfer pricing has emerged as one of the most important issue worldwide especially in taxation. Transfer pricing has been accused as the main tools to avoid tax in developed and developing countries by shifting income to lower tax rate countries so the company will save the tax expense globally. Realizing this matter, many countries have developed their transfer pricing regulation to minimize their tax leakage and maintain their nation interest for their nation welfare.

OECD TP guideline as the main source of the local TP regulation across worldwide, has delineated 5 main methods to test the arm length principle in controlled transaction i.e. TNMM, Profit Split Method, Cost Plus Method, Resale Price Method, and CUP Method. The main principle for those methods are comparison of rate of return across firms. Basically the rate of return from independent transaction is imputed to the controlled transaction in accordance to find the arm length amount of affiliated transaction.

Theoretically, the economic rate of return in market are equalized in long run in competitive market condition, nevertheless TP methodologies use accounting rate of return to substitute the economic rate of return although those rate of return concept is significantly different and can not interchangeable. The calculation of economics profit reflects the actual timing of investment and incorporates all cost including the cost of equity capital. The economic profit rate is defined as the rate that equates the discounted present value of forecasted after tax free cash flow generated by given investment project with the initial outlays required.

Accounting analysis only present a performance indicator for short period of time, therefore firms generally do not maximize their accounting rate of return because that effort do not yield highest possible return for shareholder. As the consequence, there are no enough argumentation and theory to use profit level indicator across firms as a basis to determine arms length PLI for affiliated companies.

Criticism for CPM and TNMM

CPM and TNMM are indirect method that is used in determining the arms length value of the controlled transaction. Those methods are applied by using net income as the basis of profit level indicator. Some ratio that is frequently used are operating profit to sales or total cost, gross profit to operating expense (berry ratio) etc. The arm length principle for this method is applied by comparing the independent company ratio to tested party ratio and use the difference as the basis in determining the arms length value.

Those ratio that is used in CPM and TNMM is accounting rate of return that theoretically different with the economic rate of return. We can only equalize, across the companies, the economic rate of return (not accounting rate of return) in competitive market and only in long term period. For those reason, that’s way there is no evidence to expect firms to earns the same accounting rate of return in applying arms length principle in controlled transaction.

Criticism for CP and Resale Price Method

CP and RP methods are include in direct methods in TP regulation. Basically these two methods use the same profit level indicator i.e. gross profit, but different in the application. CP use cost of goods sold (COGS) as the basis (mark up) but RP use sales of the reseller as the basis (gross profit margin).

As previously noted, there is no reason to expect gross margin or mark up to equalized across firms, therefore the application of arms length principle by using mark up/gross margin from independent transaction to controlled transaction, can not be justified.

Criticism for comparable uncontrolled price (CUP) method

This method is the most direct method and OECD’s most favorable method as declared on their TP Guideline. This method compare sales of the independent transaction directly to sales in the controlled transaction. Hence, the standard of comparability for this method is very high as compared to others methods.

For this method, the sales of tangible goods and service of independent transaction may or may not be equalized to the affiliated transaction depending on the degree of market competitiveness. When the companies operate in truly competitive market, the CUP method is accepted in the economic principle, conversely when the market is imperfectly competitive, the CUP method can not be justified. The main problem today is the difficulties in finding the pure product that is traded in competitive market. Competitive market always require several prerequisite, e.g. homogeneity of product, relatively ease in entering the market, symmetric information between buyer and seller, and ease in switching buyer or seller.

I Wayan Agus Eka

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This entry was posted on August 25, 2010 at 18:33 and is filed under Taxes.
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